FAQs: Futures and Options trading in India
WITH the exit of badla from the coming month, the
stockmarket will see the introduction of options and
futures in a big way. For investors who have difficulty
in understanding the terminologies associated with
options and futures as well as its modes of working,
here's some lucid explanation.
What are options?
An option is a contract, which gives the buyer (holder)
the right, but not the obligation, to buy or sell
specified quantity of the underlying assets, at a
specific (strike) price on or before a specified time
(expiration date).
The underlying may be commodities like wheat/ rice/
cotton/ gold/ oil or financial instruments like equity
stocks/ stock index/ bonds etc.
Important Terminology
Underlying - The specific security / asset on which an
options contract is based.
Option Premium - This is the price paid by the buyer to
the seller to acquire the right to buy or sell
Strike Price or Exercise Price - The strike or exercise
price of an option is the specified/ pre-determined
price of the underlying asset at which the same can be
bought or sold if the option buyer exercises his right
to buy/ sell on or before the expiration day.
Expiration date - The date on which the option expires
is known as Expiration Date. On Expiration date, either
the option is exercised or it expires worthless.
Exercise Date - is the date on which the option is
actually exercised. In case of European Options the
exercise date is same as the expiration date while in
case of American Options, the options contract may be
exercised any day between the purchase of the contract
and its expiration date (see European/ American Option)
Open Interest - The total number of options contracts
outstanding in the market at any given point of time.
Option Holder: is the one who buys an option which can
be a call or a put option. He enjoys the right to buy or
sell the underlying asset at a specified price on or
before specified time. His upside potential is unlimited
while losses are limited to the Premium paid by him to
the option writer.
Option seller/ writer: is the one who is obligated to
buy (in case of Put option) or to sell (in case of call
option), the underlying asset in case the buyer of the
option decides to exercise his option. His profits are
limited to the premium received from the buyer while his
downside is unlimited.
Option Class: All listed options of a particular type
(i.e., call or put) on a particular underlying
instrument, e.g., all Sensex Call Options (or) all
Sensex Put Options
Option Series: An option series consists of all the
options of a given class with the same expiration date
and strike price. E.g. BSXCMAY3600 is an options series
which includes all Sensex Call options that are traded
with Strike Price of 3600 & Expiry in May.
(BSX Stands for BSE Sensex (underlying index), C is for
Call Option , May is expiry date and strike Price is
3600)
What is Assignment?
When the holder of an option exercises his right to buy/
sell, a randomly selected option seller is assigned the
obligation to honor the underlying contract, and this
process is termed as Assignment.
What are European and American Style of options?
An American style option is the one which can be
exercised by the buyer on or before the expiration date,
i.e. anytime between the day of purchase of the option
and the day of its expiry.
The European kind of option is the one which can be
exercised by the buyer on the expiration day only & not
anytime before that.
What are Call Options?
A call option gives the holder (buyer/ one who is long
call), the right to buy specified quantity of the
underlying asset at the strike price on or before
expiration date.
The seller (one who is short call) however, has the
obligation to sell the underlying asset if the buyer of
the call option decides to exercise his option to buy.
Example: An investor buys One European call option on
Infosys at the strike price of Rs. 3500 at a premium of
Rs. 100. If the market price of Infosys on the day of
expiry is more than Rs. 3500, the option will be
exercised.
The investor will earn profits once the share price
crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100).
Suppose stock price is Rs. 3800, the option will be
exercised and the investor will buy 1 share of Infosys
from the seller of the option at Rs 3500 and sell it in
the market at Rs 3800 making a profit of Rs. 200 { (Spot
price - Strike price) - Premium}.
In another scenario, if at the time of expiry stock
price falls below Rs. 3500 say suppose it touches Rs.
3000, the buyer of the call option will choose not to
exercise his option. In this case the investor loses the
premium (Rs 100), paid which shall be the profit earned
by the seller of the call option.
What are Put Options?
A Put option gives the holder (buyer/ one who is long
Put), the right to sell specified quantity of the
underlying asset at the strike price on or before a
expiry date.
The seller of the put option (one who is short Put)
however, has the obligation to buy the underlying asset
at the strike price if the buyer decides to exercise his
option to sell.
Example: An investor buys one European Put option on
Reliance at the strike price of Rs. 300/-, at a premium
of Rs. 25/-. If the market price of Reliance, on the day
of expiry is less than Rs. 300, the option can be
exercised as it is 'in the money'.
The investor's Break even point is Rs. 275/ (Strike
Price - premium paid) i.e., investor will earn profits
if the market falls below 275.
Suppose stock price is Rs. 260, the buyer of the Put
option immediately buys Reliance share in the market @
Rs. 260/- & exercises his option selling the Reliance
share at Rs 300 to the option writer thus making a net
profit of Rs. 15 {(Strike price - Spot Price) - Premium
paid}.
In another scenario, if at the time of expiry, market
price of Reliance is Rs 320/ - , the buyer of the Put
option will choose not to exercise his option to sell as
he can sell in the market at a higher rate. In this case
the investor loses the premium paid (i.e Rs 25/-), which
shall be the profit earned by the seller of the Put
option. (Please see table)
How are options different from futures?
The significant differences in Futures and Options are
as under:
Futures are agreements/contracts to buy or sell
specified quantity of the underlying assets at a price
agreed upon by the buyer and seller, on or before a
specified time. Both the buyer and seller are obligated
to buy/sell the underlying asset.
In case of options the buyer enjoys the right and not
the obligation, to buy or sell the underlying asset.
Futures Contracts have symmetric risk profile for both
buyers as well as sellers, whereas options have
asymmetric risk profile.
In case of Options, for a buyer (or holder of the
option), the downside is limited to the premium (option
price) he has paid while the profits may be unlimited.
For a seller or writer of an option, however, the
downside is unlimited while profits are limited to the
premium he has received from the buyer.
The futures contracts prices are affected mainly by the
prices of the underlying asset. Prices of options are
however, affected by prices of the underlying asset,
time remaining for expiry of the contract and volatility
of the underlying asset.
It costs nothing to enter into a futures contract
whereas there is a cost of entering into an options
contract, termed as Premium.
Explain In the Money, At the Money and Out of the money
Options.
An option is said to be 'at-the-money', when the
option's strike price is equal to the underlying asset
price. This is true for both puts and calls.
A call option is said to be in-the-money when the strike
price of the option is less than the underlying asset
price. For example, a Sensex call option with strike of
3900 is 'in-the-money', when the spot Sensex is at 4100
as the call option has value.
The call holder has the right to buy a Sensex at 3900,
no matter how much the spot market price has risen. And
with the current price at 4100, a profit can be made by
selling Sensex at this higher price.
On the other hand, a call option is out-of-the-money
when the strike price is greater than the underlying
asset price. Using the earlier example of Sensex call
option, if the Sensex falls to 3700, the call option no
longer has positive exercise value. The call holder will
not exercise the option to buy Sensex at 3900 when the
current price is at 3700. (Please see table)
A put option is in-the-money when the strike price of
the option is greater than the spot price of the
underlying asset. For example, a Sensex put at strike of
4400 is in-the-money when the Sensex is at 4100. When
this is the case, the put option has value because the
put holder can sell the Sensex at 4400, an amount
greater than the current Sensex of 4100.
Likewise, a put option is out-of-the-money when the
strike price is less than the spot price of underlying
asset. In the above example, the buyer of Sensex put
option won't exercise the option when the spot is at
4800. The put no longer has positive exercise value.
Options are said to be deep in-the-money (or deep
out-of-the-money) if the exercise price is at
significant variance with the underlying asset price.
What are Covered and Naked Calls?
A call option position that is covered by an opposite
position in the underlying instrument (for example
shares, commodities etc), is called a covered call.
Writing covered calls involves writing call options when
the shares that might have to be delivered (if option
holder exercises his right to buy), are already owned.
E.g. A writer writes a call on Reliance and at the same
time holds shares of Reliance so that if the call is
exercised by the buyer, he can deliver the stock.
Covered calls are far less risky than naked calls (where
there is no opposite position in the underlying), since
the worst that can happen is that the investor is
required to sell shares already owned at below their
market value.
When a physical delivery uncovered/ naked call is
assigned an exercise, the writer will have to purchase
the underlying asset to meet his call obligation and his
loss will be the excess of the purchase price over the
exercise price of the call reduced by the premium
received for writing the call.
What is the Intrinsic Value of an option?
The intrinsic value of an option is defined as the
amount by which an option is in-the-money, or the
immediate exercise value of the option when the
underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike
Price
For a put option: Intrinsic Value = Strike Price - Spot
Price
The intrinsic value of an option must be a positive
number or 0. It cannot be negative. For a call option,
the strike price must be less than the price of the
underlying asset for the call to have an intrinsic value
greater than 0. For a put option, the strike price must
be greater than the underlying asset price for it to
have intrinsic value.
Explain Time Value with reference to Options.
Time value is the amount option buyers are willing to
pay for the possibility that the option may become
profitable prior to expiration due to favorable change
in the price of the underlying. An option loses its time
value as its expiration date nears. At expiration an
option is worth only its intrinsic value. Time value
cannot be negative.
What are the factors that affect the value of an option
(premium)?
There are two types of factors that affect the value of
the option premium:
Quantifiable Factors:
underlying stock price,
the strike price of the option,
the volatility of the underlying stock,
the time to expiration and;
the risk free interest rate.
Non-Quantifiable Factors :
Market participants' varying estimates of the underlying
asset's future volatility
Individuals' varying estimates of future performance of
the underlying asset, based on fundamental or technical
analysis
The effect of supply & demand- both in the options
marketplace and in the market for the underlying asset
The "depth" of the market for that option - the number
of transactions and the contract's trading volume on any
given day.
What are different pricing models for options?
The theoretical option pricing models are used by option
traders for calculating the fair value of an option on
the basis of the earlier mentioned influencing factors.
An option pricing model assists the trader in keeping
the prices of calls & puts in proper numerical
relationship to each other & helping the trader make
bids & offer quickly. The two most popular option
pricing models are:
Black Scholes Model which assumes that percentage change
in the price of underlying follows a normal
distribution.
Binomial Model which assumes that percentage change in
price of the underlying follows a binomial distribution.
Who decides on the premium paid on options & how is it
calculated?
Options Premium is not fixed by the Exchange. The fair
value/ theoretical price of an option can be known with
the help of pricing models and then depending on market
conditions the price is determined by competitive bids
and offers in the trading environment.
An option's premium / price is the sum of Intrinsic
value and time value (explained above). If the price of
the underlying stock is held constant, the intrinsic
value portion of an option premium will remain constant
as well.
Therefore, any change in the price of the option will be
entirely due to a change in the option's time value.
The time value component of the option premium can
change in response to a change in the volatility of the
underlying, the time to expiry, interest rate
fluctuations, dividend payments and to the immediate
effect of supply and demand for both the underlying and
its option.
Explain the Option Greeks?
The price of an Option depends on certain factors like
price and volatility of the underlying, time to expiry
etc. The option Greeks are the tools that measure the
sensitivity of the option price to the above mentioned
factors.
They are often used by professional traders for trading
and managing the risk of large positions in options and
stocks. These Option Greeks are:
Delta: is the option Greek that measures the estimated
change in option premium/price for a change in the price
of the underlying.
Gamma: measures the estimated change in the Delta of an
option for a change in the price of the underlying
Vega : measures estimated change in the option price for
a change in the volatility of the underlying.
Theta: measures the estimated change in the option price
for a change in the time to option expiry.
Rho: measures the estimated change in the option price
for a change in the risk free interest rates.
What is an Option Calculator?
An option calculator is a tool to calculate the price of
an Option on the basis of various influencing factors
like the price of the underlying and its volatility,
time to expiry, risk free interest rate etc.
It also helps the user to understand how a change in any
one of the factors or more, will affect the option
price.
Who are the likely players in the Options Market?
Developmental institutions, Mutual Funds, FIs, FIIs,
Brokers, Retail Participants are the likely players in
the Options Market.
Why do I invest in Options? What do options offer me?
Besides offering flexibility to the buyer in form of
right to buy or sell, the major advantage of options is
their versatility. They can be as conservative or as
speculative as one's investment strategy dictates.
Some of the benefits of Options are as under:
High leverage as by investing small amount of capital
(in form of premium), one can take exposure in the
underlying asset of much greater value.
Pre-known maximum risk for an option buyer
Large profit potential and limited risk for option buyer
One can protect his equity portfolio from a decline in
the market by way of buying a protective put wherein one
buys puts against an existing stock position.
This option position can supply the insurance needed to
overcome the uncertainty of the marketplace. Hence, by
paying a relatively small premium (compared to the
market value of the stock), an investor knows that no
matter how far the stock drops, it can be sold at the
strike price of the Put anytime until the Put expires.
E.g. An investor holding 1 share of Infosys at a market
price of Rs 3800/-thinks that the stock is over-valued
and decides to buy a Put option' at a strike price of Rs.
3800/- by paying a premium of Rs 200/-
If the market price of Infosys comes down to Rs 3000/-,
he can still sell it at Rs 3800/- by exercising his put
option. Thus, by paying premium of Rs 200,his position
is insured in the underlying stock.
How can I use options?
If you anticipate a certain directional movement in the
price of a stock, the right to buy or sell that stock at
a predetermined price, for a specific duration of time
can offer an attractive investment opportunity.
The decision as to what type of option to buy is
dependent on whether your outlook for the respective
security is positive (bullish) or negative (bearish).
If your outlook is positive, buying a call option
creates the opportunity to share in the upside potential
of a stock without having to risk more than a fraction
of its market value (premium paid).
Conversely, if you anticipate downward movement, buying
a put option will enable you to protect against downside
risk without limiting profit potential.
Purchasing options offer you the ability to position
yourself accordingly with your market expectations in a
manner such that you can both profit and protect with
limited risk.
Once I have bought an option and paid the premium for
it, how does it get settled?
Option is a contract which has a market value like any
other tradable commodity. Once an option is bought there
are following alternatives that an option holder has:
You can sell an option of the same series as the one you
had bought and close out /square off your position in
that option at any time on or before the expiration.
You can exercise the option on the expiration day in
case of European Option or; on or before the expiration
day in case of an American option. In case the option is
'Out of Money' at the time of expiry, it will expire
worthless.
What are the risks involved for an options buyer?
The risk/ loss of an option buyer is limited to the
premium that he has paid.
What are the risks for an Option writer?
The risk of an Options Writer is unlimited where his
gains are limited to the Premiums earned. When a
physical delivery uncovered call is exercised upon, the
writer will have to purchase the underlying asset and
his loss will be the excess of the purchase price over
the exercise price of the call reduced by the premium
received for writing the call.
The writer of a put option bears a risk of loss if the
value of the underlying asset declines below the
exercise price. The writer of a put bears the risk of a
decline in the price of the underlying asset potentially
to zero.
How can an option writer take care of his risk?
Option writing is a specialized job which is suitable
only for the knowledgeable investor who understands the
risks, has the financial capacity and has sufficient
liquid assets to meet applicable margin requirements.
The risk of being an option writer may be reduced by the
purchase of other options on the same underlying asset
thereby assuming a spread position or by acquiring other
types of hedging positions in the options/ futures and
other correlated markets.
Who can write options in Indian derivatives market?
In the Indian Derivatives market, Sebi has not created
any particular category of options writers. Any market
participant can write options. However, margin
requirements are stringent for options writers.
What are Stock Index Options?
The Stock Index Options are options where the underlying
asset is a Stock Index for e.g. Options on S&P 500
Index/ Options on BSE Sensex etc.
Index Options were first introduced by Chicago Board of
Options Exchange in 1983 on its Index 'S&P 100'. As
opposed to options on Individual stocks, index options
give an investor the right to buy or sell the value of
an index which represents group of stocks.
What are the uses of Index Options?
Index options enable investors to gain exposure to a
broad market, with one trading decision and frequently
with one transaction. To obtain the same level of
diversification using individual stocks or individual
equity options, numerous decisions and trades would be
necessary.
Since, broad exposure can be gained with one trade,
transaction cost is also reduced by using Index Options.
As a percentage of the underlying value, premiums of
index options are usually lower than those of equity
options as equity options are more volatile than the
Index.
Who would use index options?
Index Options are effective enough to appeal to a broad
spectrum of users, from conservative investors to more
aggressive stock market traders.
Individual investors might wish to capitalize on market
opinions (bullish, bearish or neutral) by acting on
their views of the broad market or one of its many
sectors.
The more sophisticated market professionals might find
the variety of index option contracts excellent tools
for enhancing market timing decisions and adjusting
asset mixes for asset allocation.
To a market professional, managing risks associated with
large equity positions may mean using index options to
either reduce risk or increase market exposure.
What are Options on individual stocks?
Options contracts where the underlying asset is an
equity stock, are termed as Options on stocks. They are
mostly American style options cash settled or settled by
physical delivery.
Prices are normally quoted in terms of the premium per
share, although each contract is invariably for a larger
number of shares, e.g. 100.
How will introduction of options in specific stocks
benefit an investor?
Options can offer an investor the flexibility one needs
for countless investment situations. An investor can
create hedging position or an entirely speculative one,
through various strategies that reflect his tolerance
for risk.
Investors of equity stock options will enjoy more
leverage than their counterparts who invest in the
underlying stock market itself in form of greater
exposure by paying a small amount as premium.
Investors can also use options in specific stocks to
hedge their holding positions in the underlying (i.e.
long in the stock itself), by buying a Protective Put.
Thus they will insure their portfolio of equity stocks
by paying premium.
ESOPs (Employees' stock options) have become a popular
compensation tool with more and more companies offering
the same to their employees. ESOPs are subject to lock
in periods, which could reduce capital gains in falling
markets - Derivatives can help arrest that loss along
with tax savings.
An ESOPs holder can buy Put Option in the underlying
stock & exercise the same if the market falls below the
strike price & lock in his sale prices
Whether exchange traded equity options are issued by
companies underlying them.
The equity options traded on exchange are not issued by
the companies underlying them. Companies do not have any
say in selection of underlying equity for options.
Whether the holders of equity options contracts have all
the rights that the owners of equity shares have.
Holder of the equity options contracts do not have any
of the rights that owners of equity shares have - such
as voting rights and the right to receive bonus,
dividend etc. To obtain these rights a Call option
holder must exercise his contract and take delivery of
the underlying equity shares.
What are Leaps (long term equity anticipation
securities)?
Long term equity anticipation securities (Leaps) are
long-dated put and call options on common stocks or ADRs.
These long-term options provide the holder the right to
purchase, in case of a call, or sell, in case of a put,
a specified number of stock shares at a pre-determined
price up to the expiration date of the option, which can
be three years in the future.
What are exotic Options?
Derivatives with more complicated payoffs than the
standard European or American calls and puts are
referred to as Exotic Options. Some of the examples of
exotic options are as under:
Barrier Options: where the payoff depends on whether the
underlying asset's price reaches a certain level during
a certain period of time.
CAPS traded on CBOE (traded on the S&P 100 & S&P 500)
are examples of Barrier Options where the pay-out is
capped so that it cannot exceed $30.
A Call CAP is automatically exercised on a day when the
index closes more than $30 above the strike price. A put
CAP is automatically exercised on a day when the index
closes more than $30 below the cap level.
Binary Options: are options with discontinuous payoffs.
A simple example would be an option which pays off if
price of an Infosys share ends up above the strike price
of say Rs. 4000 & pays off nothing if it ends up below
the strike.
What are Over-The-Counter Options?
Over-The-Counter options are those dealt directly
between counter-parties and are completely flexible and
customized. There is some standardization for ease of
trading in the busiest markets, but the precise details
of each transaction are freely negotiable between buyer
and seller.
Where can I trade in Options and Futures contracts.
Like stocks, options and futures contracts are also
traded on any exchange. In Bombay Stock Exchange, stocks
are traded on BSE On Line Trading (BOLT) system and
options and futures are traded on Derivatives Trading
and Settlement System (DTSS).
What is the underlying in case of Options being
introduced by BSE?
The underlying for the index options is the BSE 30
Sensex, which is the benchmark index of Indian Capital
markets, comprising 30 scrips.
What are the contract specifications of Sensex Options?
BSE's first index options is based on BSE 30 Sensex. The
Sensex options would be European style of options i.e.
the options would be exercised only on the day of
expiry.
They will be premium style i.e. the buyer of the option
will pay premium to the options writer in cash at the
time of entering into the contract.
The Premium and Options Settlement Value (difference
between Strike and Spot price at the time of expiry),
will be quoted in Sensex points The contract multiplier
for Sensex options is INR 50 which means that monetary
value of the Premium and Settlement value will be
calculated by multiplying the Sensex Points by 50.
For e.g. if Premium quoted for a Sensex options is 50
Sensex points, its monetary value would be Rs. 2500
(50*50).
There will be at-least 5 strikes (2 In the Money, 1 Near
the money, 2 Out of the money), available at any point
of time. The expiration day for Sensex option is the
last Thursday of Contract month.
If it is a holiday, the immediately preceding business
day will be the expiration day.
There will be three contract month series (Near, middle
and far) available for trading at any point of time. The
settlement value will be the closing value of the Sensex
on the expiry day.
The tick size for Sensex option is 0.1 Sensex points (INR
5). This means the minimum price fluctuation in the
value of the option premium can be 0.1.In Rupee terms
this translates to minimum price fluctuation of Rs 5. (
Tick Size * Multiplier =0.1* 50).
What is SPAN?
Specific Portfolio Analysis of Risk (SPAN) is a
worldwide acknowledged risk management system developed
by Chicago Mercantile Exchange (CME). It is a
portfolio-based margin calculating system adopted by all
major Derivatives Exchanges.
Objective of SPAN
SPAN identifies overall risk in a complete portfolio of
futures and options at the same time recognizing the
unique exposures associated with both inter-month and
inter-commodity risk relationships.
It determines the largest loss that a portfolio might
suffer with in the period specified by the exchange i.e
may be day (or) two. BSE has licensed SPAN from CME for
calculating margin requirements at the Exchange level.
At the same time members can also calculate margin
requirements of their clients by using PC SPAN.
What is PC-SPAN?
PC-SPAN is an easy to use program for PC's which
calculates SPAN margin requirements at the members' end.
How PC SPAN works:
Each business day the exchange generates risk parameter
file (parameters set by the exchange ) which can be down
loaded by the member.
The position file consisting of members' trades (own +
clients) and the risk parameter file has to be fed into
PC-SPAN for calculation of Margins payable for the
trades executed.
What will be the new margining system in the case of
Options and futures?
A portfolio based margining model (SPAN), would be
adopted which will take an integrated view of the risk
involved in the portfolio of each individual client
comprising of his positions in all the derivatives
contract traded on the Derivatives Segment.
The Initial Margin would be based on worst-case loss of
the portfolio of a client to cover 99 per cent VaR over
two days horizon. The Initial Margin would be netted at
client level and shall be on gross basis at the
Trading/Clearing member level.The Portfolio will be
marked to market on a daily basis.
How will the assignment of options takes place?
On Exercise of an Option by an Option Holder, the
trading software will assign the exercised option to the
option writer on random basis based on a specified
algorithm.
What does an investor need to do to trade in options?
An investor has to register himself with a broker who is
a member of the BSE Derivatives Segment.
If he wants to buy an option, he can place the order for
buying a Sensex Call or Put option with the broker. The
Premium has to be paid up-front in cash.
He can either hold on to the contract till its expiry or
square up his position by entering into a reverse
trade.If he closes out his position, he will receive
Premium in cash, the next day.
If the investor holds the position till expiry day and
decides to exercise the contract, he will receive the
difference between Option Settlement price and the
Strike price in cash.If he does not exercise his option,
it will expire worthless.
If an investor wants to write/ sell an option, he will
place an order for selling Sensex Call/ Put option.
Initial margin based on his position will have to be
paid up-front (adjusted from the collateral deposited
with his broker) and he will receive the premium in
cash, the next day.
Everyday his position will be marked to market and
variance margin will have to be paid. He can close out
his position by a buying the option by paying requisite
premium. The initial margin which he had paid on the
first position will be refunded.
If he waits till expiry, and the option is exercised, he
will have to pay the difference in the Strike price and
the options settlement price, in cash. If the option is
not exercised, the investor will not have to pay
anything.
What steps will be taken by the exchange to create
awareness about options amongst masses?
The exchange is conducting free of cost futures and
options awareness programs for member brokers and their
clients. This will be conducted across the country to
reach investors at large. |
